Inflation report in focus

• BoE’s Inflation Report likely to include downward revisions to growth and inflation projections.  
• Releases for June to remove some uncertainty over bank holiday impact on UK economy.  
• July’s Chinese releases to suggest activity is firming.  

Initial market reaction belies some merit to ECB’s latest proposals ...Market reaction to the ECB’s failure to provide instant relief was predictable. Spanish 10-year yields rose back above the psychologically important 7%, but remain below the level before ECB President Draghi’s recent comments. The ECB’s plan of standing ready to supplement EFSF/ESM bond purchases increases the potential firepower of these funds to contain financial market contagion. This could ease the current crisis if Spain’s (and possibly Italy’s) government chooses to ask for support. In turn, this could bolster confidence and improve growth prospects. In the short term, the crisis is likely to continue to generate headwinds to activity.

China is the global focus ... The coming week sees few global releases, except the latest monthly news from China. July’s releases should continue to suggest firmer activity in China, with fixed investment increasingly boosted by local government spending and an acceleration in industrial output consistent with recent PMIs. We believe Chinese activity reached a nadir at the start of 2012 and has been firming since. Soft import growth has exacerbated concerns, but we think these numbers are exaggerating import weakness particularly in raw commodities. We forecast further monetary policy easing across Q3, but with the aim of supporting recovery.

Downbeat Inflation Report... The MPC chose to leave policy unchanged this week and the coming week will provide some insight into the Committee's thinking as the Governor presents the latest quarterly inflation report. Within weeks of May's Report, Governor King suggested it had become dated and was voting for further stimulus, which the Committee eventually adopted in July. August's Report looks set to catch up with this outlook and we expect the Bank to revise both its GDP and inflation projections, the latter impacted by the decline in global commodity prices. Governor King’s recent press conferences have adopted a more downbeat tone than the broader Report and we expect a continued focus on the impact of the euro area crisis on the UK economy as a whole.

June’s data details bank holiday effect ... The coming week should start to clear the uncertainty surrounding UK activity. The coming week sees June’s industrial and construction sector updates, which will replace the official estimates included in the preliminary Q2 GDP release. Much uncertainty surrounds the impact of the bank holiday effect and the upcoming data will define the scale of decline in June. We estimate that while manufacturing output may be revised lower than the initial estimate, the wider industrial measure should be revised a touch firmer to -1.2% (from -1.3%). This is unlikely to be sufficient to see GDP as a whole revised higher in the next release, although we hold out the possibility that Q2 could eventually be revised higher after the full revision process.

Little US guidance ...Today’s US payrolls report was ambiguous for the outlook for the US. The last time the Federal Reserve used outright QE, in late 2010, payrolls had contracted from June to September inclusive. The employment report is far from suggesting this scale of weakness and is more in keeping with the sub-100ks that prompted 'operation twist' in 2011 and in the current phase. The latest Fed meeting stated that it would "closely monitor" developments and provide additional accommodation as needed. Our global team expects to see QE in September, a view becoming increasingly widespread in financial markets. There is little this week to provide further evidence on the US economy, which will leave markets even more focused on global developments.

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